How We'll Capitalize on Fed Cowardice

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MoneyMorning.com Michael E. Lewitt writes: Markets delivered a resounding Bronx cheer to the Federal Reserve on Friday after that confederacy of dunces failed to raise interest rates at its highly anticipated, two-day September meeting.

The Dow Jones Industrial Average plunged by 290 points (1.74%) while the S&P 500 followed by 32 points (1.62%) and the Nasdaq Composite Index dropped by 67 points (1.32%).

On the week, the Dow lost only 49 points or 0.3% to close at 16,384.79 while the S&P shed only 3 points or 0.2% to end at 1958.03. Both indices remain down on the year. The tech-heavy Nasdaq managed to eke out a five point or 0.1% gain on the week to close at 4827.23 and remain up on the year.

Markets ended the week confused about the future direction of Fed policy. The former tenured economics professors who guide monetary policy added a new mandate to their existing dual mandates to maintain high employment and price stability.

The Fed's Farcical Excuses Will Hurt Equities

This new mandate is to worry about the health of foreign economies. And while they didn't name the economy they were particularly worried about – it was obviously China.

Karl Marx once wrote that history repeats itself – the first time as tragedy, the second as farce. So perhaps we can think about what is happening to this country's economy as having moved from the tragedy of on-going zero interest rate policies to the farce of not raising them by a paltry 25 basis points, due to global economic conditions…Janet Yellen has effectively now handed over America's economic policy to China.

After all, the Fed has fallen so far behind the curve in raising rates that it risks damaging its credibility beyond all repair. Stock markets have already entered correction territory (down 10% from their recent highs). If investors decide that the Fed doesn't know what it is doing (something I have believed for a long time), the market may not find a bottom until stocks lose a lot more altitude.

One data point on which savvy investors like Doubleline's Jeff Gundlach are focusing is the junk bond market. The average yield on the Barclay's High Yield Bond Index was 7.26% on Sept. 18, while the average spread was 547 basis points.

The two poorest performing sectors of the market, energy and basic industry, are trading at distressed yields and spreads of 10.97%/885 and 10.05%/813, respectively, down slightly from their worst levels of the year. These two sectors represent more than 20% of the market.

These Funds Portend More Weakness to Come

To place this in context, a little more than a year ago in the summer of 2014, the average yield on the energy sector was below 6%. The poor performance of junk debt is a serious signal of economic weakness that is focused in, but not limited to, commodity weakness.

It would be imprudent to expect equities to rally in the face of what junk bonds are telling us. That said, the average yield and spread of 7.26%/547 are not that high in historical terms. Previous periods of market distress have seen the market reach much higher levels. What is keeping these levels relatively low is zero interest rates, which are likely to persist for a prolonged period of time under our cowardly Fed and a weak economy.

There are two big junk bond ETFs: the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA: HYG) and the SPDR Barclays High Yield Bond ETF (NYSEARCA: JNK). There are minor differences in the number of holdings and fees between the two but they tend to track each other in performance.

The high yield market is likely heading for a period of underperformance that also portends similar underperformance in equities. Investors can sell these ETFs short as protection for the turbulence ahead.

Source http://moneymorning.com/2015/09/20/how-well-capitalize-on-fed-cowardice/

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